Bretton Woods System

While nominally tied to gold, the system essentially put the market economies of the world on a dollar standard — in other words, the U.S. dollar served as the world’s principal currency, and countries held most of their reserves in interest-bearing dollar securities.[1]

Contents

Workings

During World War II, Great Britain and the United States outlined the postwar monetary system. Their plan, approved by more than 40 countries at the Bretton Woods Conference in July 1944, aimed to correct the perceived deficiencies of the interwar gold exchange standard. These included the volatility of floating exchange rates, the inflexibility of fixed exchange rates, and reliance on an adjustment mechanism for countries with payment surpluses or deficits; these problems were often resolved by recession and deflation in deficit countries coupled with expansion and inflation in surplus countries. The agreement that resulted from the conference led to the creation of the International Monetary Fund (IMF), which countries joined by paying a subscription. Members agreed to maintain a system of fixed but adjustable exchange rates. Countries with payment deficits could borrow from the fund, while those with surpluses would lend. If deficits or surpluses persisted, the agreement provided for changes in exchange rates. The IMF began operations in 1947, with the U.S. dollar serving as the fund’s reserve currency and the price of gold fixed at $35 per ounce. The U.S. agreed to maintain that price by buying or selling gold.

Postwar recovery, low inflation, growth of trade and payments, and the buildup of international reserves in industrial countries permitted the new system to come into full operation at the end of 1958. Although a vestigial tie to gold remained with the gold price staying at $35 per ounce, the Bretton Woods system essentially put the market economies of the world on a dollar standard—in other words, the U.S. dollar served as the world’s principal currency, and countries held most of their reserves in interest-bearing dollar securities.[1]

Interpretation

The new system was designed to make the production of banknotes even more 'flexible'. The gold reserves of the whole world should be concentrated in a single pool, the Fed would redeem its notes while all others would keep the US dollar as reserve. It was a logical choice, as the United States have attracted much gold and after WWII Fort Knox became the largest gold storage in the world. (England, represented by Lord Keynes, tried to push for a pure paper money, but it didn't come to be.)

To reduce the resulting dependency on the Fed, and to make it politically acceptable, two organizations were created: the International Monetary Fund (IMF) and the World Bank, both to influence the distribution of new banknotes. They would supply short-term (IMF) and long-term (WB) credit to member states in trouble, primarily the board members. They survived the collapse of Bretton Woods.

The growth of inflation, the main purpose of the Bretton Woods, was so successful, that the Fed eventually ran out of gold and had to suspend its payments in 1971. That was the end of the so-called gold standard and its variants.[2]

Collapse

The dollar became the most widely used currency in international trade, even in trade between countries other than the United States. It was the unit in which countries expressed their exchange rate. Countries maintained their "official" exchange rates by buying and selling U.S. dollars and held dollars as their primary reserve currency for that purpose. The existence of a dollar standard did not prevent other countries from changing their exchange rates, just as the gold standard did not prevent other currencies from "devaluing" or "appreciating" in terms of gold. In time, however, the fixed price of gold became increasingly difficult for the United States to maintain. Many countries devalued or revalued their currencies, including major economic powers such as the United Kingdom (in 1967), Germany, and France (both in 1969). Yet in practice the United States was not free to determine its own exchange rate or its balance of payments position. Monetary expansion in the United States provided reserves for other countries; monetary contraction absorbed reserves. Central banks could convert dollars into gold, and they did, especially in the early years. As the stock of dollars held by central banks outside the United States rose and the U.S. gold stock dwindled, the United States could not honour its commitment to convert gold into dollars at the fixed rate of $35 per ounce. The Bretton Woods system of fixed exchange rates appeared doomed. Governments and central banks tried for years to find a way to extend its life, but they could not agree on a solution. The end came on Aug. 15, 1971, when Pres. Richard M. Nixon announced that the United States would no longer sell gold.[1]

Predictions

The system was criticized from the outset by Henry Hazlitt and he predicted its eventual fall.[3] The collapse of the Bretton Woods System and the following rise of the gold price has been predicted by other Austrian economists as well and is covered in the following:

Aftermath

After the Bretton Woods system ended in 1973, most countries allowed their currencies to float, but this situation soon changed. Generally, small countries with relatively large trade sectors disliked floating rates. They wanted to avoid the often transitory but sometimes large changes in prices and costs arising in the foreign exchange market. Many of the smaller Asian economies, along with countries in Central America and the Caribbean, fixed their exchange rates to the U.S. dollar. Countries such as the Netherlands and Austria, both of which traded heavily with West Germany, soon fixed their exchange rates to the German mark. These countries ceased conducting independent central bank policy, so that when the Bundesbank or the U.S. Federal Reserve changed interest rates, countries that fixed their exchange rate to the mark or the dollar changed their interest rates as well.

Large economies such as those of the United States, Japan, and Great Britain continued to float their currencies, as did Switzerland and Canada—both relatively small economies that have preferred to retain some influence over domestic monetary conditions. Hong Kong made the opposite choice. Although it was a British colony at the time and later a part of China, it chose to fix its exchange rate to the U.S. dollar. The method it revived was a 19th-century system known as a currency board. In such a case there is no central bank and the exchange rate is fixed. Local banks increase the number of Hong Kong dollars only when they receive additional U.S. dollars, and they reduce the stock of Hong Kong dollars when U.S. dollar holdings decline. Hong Kong’s experience with its currency board encouraged a few, mainly small countries to follow its lead. Some stepped even further away from autonomous policy by adopting the U.S. dollar as their domestic currency. The most notable change of this general type was the decision by most of the continental European countries to surrender their local currencies in exchange for a new common currency, the Euro.[1]